SBA LENDING AND THE ECONOMICS OF CREDIT
credit markets. They also show that the corresponding disequilibrium would unlikely be just a temporary phenomenon.
Importantly Stiglitz and Weiss show that, in equilibrium a loan market may be characterized by credit rationing. They reason that banks making loans are concerned about the interest rate they receive on the loan and the riskiness of the loan. However the interest rate may itself affect the riskiness of the pool of bank loans by either sorting potential borrowers (the adverse selection effect) or infl uencing the actions of borrowers (the moral hazard effect). Both effects derive directly from the imperfect information that is present in loan markets after banks have evaluated loan applications. When the price (interest rate) affects the nature of the transaction, it is unlikely that price will also clear the market.
The adverse selection aspect of interest rates is a consequence of different borrowers having different probabilities of repaying their loan. The expected return to the bank obviously depends on the probability of repayment, so the bank would like to be able to identify borrowers who are more likely to repay. But it is diffi cult to identify ‘good borrowers’. Typically the bank will use a variety of screening devices to do so. The interest rate that a borrower is willing to pay may act as one such screening device. For example, those who are willing to pay a higher interest rate are likely to be, on average, worse risks. These borrowers are willing to borrow at a higher interest rate because they perceive their probability of repaying the loan to be lower. As the interest rate rises, the average ‘riskiness’ of those who borrow increases, and this may actually result in lowering the bank’s expected profi ts.
Similarly, as the interest rate and other terms of the contract change, the behavior of the borrower is likely also to change. For instance, raising the interest rate decreases the return on projects which succeed. Higher interest rates may thus induce fi rms to undertake projects with lower probabilities of success but higher pay-offs when successful. This is the moral hazard problem.
For these reasons, the expected return to the bank may increase less rapidly than the interest rate and, beyond a point, may actually decrease.
Clearly, under these conditions, it is conceivable that the demand for credit may exceed the supply of credit in equilibrium. Although traditional analysis would argue that, in the presence of an excess demand for credit unsatisfi ed borrowers would offer to pay a higher interest rate to the bank, bidding up the interest rate until demand equals supply, it does not happen in this case. This is because the bank would not lend to someone who offered to pay the higher interest rate, as such a borrower is likely to be a worse risk than the average current borrower (Stiglitz and Weiss, 1981). The expected return on a loan to this borrower at the higher interest rate is actually lower than the expected return on the loans the bank is currently making. Hence
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there are no competitive forces leading supply to equal demand, and credit is rationed.
Of course the interest rate is not the only term of the contract which is important. Stiglitz and Weiss report that the amount of credit extended, and the amount of collateral the bank demands of the borrower, will also affect the behavior of borrowers and the distribution of borrowers. And, as with interest rates, increasing the collateral requirements of borrowers may actually decrease the returns to the lender, by either decreasing the average degree of risk aversion of the pool of borrowers or inducing borrowers to undertake riskier projects.
Consequently it may not be profi table to raise the interest rate or collateral requirements when a bank has an excess demand for credit; instead, banks may deny loans to borrowers who are observationally indistinguishable from those who receive loans. This is what Stiglitz and Weiss (1981) refer to as ‘credit rationing’.
Importance of Lending Relationships
Kane and Malkiel (1965) come to a similar conclusion about the possibility of banks rationing credit, but they also suggest that the extent of credit rationing depends on the strength of existing customer relationships; the size, stability and prospects for future growth of deposits; and the existence of profi table future lending opportunities. That is, loans may be rationed to current and prospective borrowers in accordance with the cohesion of the existing relationships along with expectations about the future profi tability of those relationships.
Petersen and Raghuram (1994) extended the notion that relationships are important factors in determining credit rationing. They suggested that the causes of credit rationing, adverse selection and moral hazard, may be more prominent when fi rms are young or small. However, through close and continued interaction, a fi rm may provide a lender with suffi cient information about, and a voice in, the fi rm’s affairs so as to lower the cost and increase the availability of credit. These authors also suggest that an important dimension of a relationship is its duration. Conditional on its positive past experience with the borrower, the bank may expect future loans to be less risky. This should reduce its expected cost of lending and increase its willingness to provide funds.
Petersen and Rajan suggest that, in addition to interaction over time, relationships can be built through interaction over multiple products. That is, borrowers may obtain more than just loans from a bank. Borrowers may purchase a variety of fi nancial services and also maintain checking and savings accounts with the bank. These added dimensions of a relationship
can affect the fi rm’s borrowing cost in two ways. First, they increase the precision of the lender’s information about the borrower. For example, the lender can learn about the fi rm’s sales by monitoring the cash fl owing through its checking account or by factoring the fi rm’s accounts receivables.
Second, the lender can spread any fi xed costs of producing information about the fi rm over multiple products. Petersen and Rajan report that both effects reduce the lender’s costs of providing loans and services, and the former effect increases the availability of funds to the fi rm.
Berger and Udell (1995) also study the importance of relationships in the extension of credit to small fi rms. They fi nd that small fi rms with longer banking relationships borrow at lower rates and are less likely to pledge collateral than are other small fi rms. These effects appear to be both economically and statistically signifi cant. According to Berger and Udell, these results suggest that banks accumulate increasing amounts of this private information over the duration of the bank–borrower relationship and use this information to refi ne their loan contract terms.
Because relationships may be more costly for small businesses to establish relative to large businesses, and because lack of relationships may lead to severe credit rationing in the small business credit market, some form of government intervention to assist small businesses in establishing relation- ships with lenders may be appropriate. However the nature of intervention must be carefully evaluated. SBA’s guaranteed lending programs may well be a reasonable intervention as they serve as a form of substitute for small business collateral. The program also reduces the risk to the lender of estab- lishing a relationship with informationally opaque small business borrowers.
Finally the SBA loan guarantee programs may improve the intermedia- tion process by lowering the risk to the lender of extending longer-term loans, ones that more closely meet the needs of small businesses for capital investment. After all, the problem Congress is said to have worried about is long-term credit for small businesses.